By Allan Swan
Too often, the principals of a professional practice find that as their practices grow and evolve, they can encounter pitfalls and obstacles with regard to taxation. There are a variety of tax outcomes that can be affected over time — for example capital gains tax (CGT), land transfer duty, and the asset withholding tax on real estate sales.
Some of the pitfalls will not be able to be foreseen, for example because of subsequent changes to the relevant legislation. The stripping back in recent times of concessional and non-concessional superannuation contribution limits has had a range of adverse outcomes for professional practitioners and many other taxpayers.
For example, the stripping back referred to has meant that the strategy for some professional practitioners to qualify for the small business CGT concessions has had to change. In the past, they may have been able to make large non-concessional contributions into superannuation in the lead up to an exit. The options now may include personally acquiring residential assets, for example a beach house that is not rented out. Assets that do not generate income are not considered to be CGT assets within the meaning of sections 152-15 and 152-20 of ITAA 1997.
By contrast, some of the other pitfalls usually will be able to be addressed regardless of the existing business structure, for example satisfying the GST going concern requirement in section 38-325 of the GST legislation.
The remaining pitfalls, however, will generally only be encountered through a lack of forward planning. Negotiating around those pitfalls (where that is even possible) will often come at cost.
Five pitfalls to watch
There are five pitfalls that are summarised below. Each can usually be anticipated when practice structures are being established or reviewed. They are:
- Lack of flexibility in distribution of income.
- Inability to retain profits in a proprietary company, other than the trading entity.
- Lack of eligibility for the small business CGT concessions for intellectual property.
- Lack of eligibility for the small business CGT concessions for business premises.
- Lack of eligibility for a CGT exemption for total and permanent disability cover, and trauma life insurance proceeds.
1/ Traditionally professional practices were partnerships of individuals. The lack of flexibility of such partnerships encouraged the use of service trusts.
These days, with most professional practices established in more recent years being incorporated practices, service trusts are only needed where the splitting of income is not possible under the practice structure, for example because the shares in the practice are solely owned by the principals.
There are other options available that can take care of such flexibility in regard to distributions.
2/ Frequently, when a professional practice is commenced, the prospect of excess income is not forefront of mind. As the practice becomes more successful, the prospect of reducing immediate income tax liabilities becomes an attractive one.
3/ From an asset protection viewpoint, intellectual property is frequently held away from trading entities. This can mean that the connection to the trading business becomes too remote for the intellectual property to qualify as “active assets” for the purpose of the small business CGT concessions.
4/ As a result of the tight criteria imposed by Division 152, it is important that eligibility for the concessions be monitored over time, as ensuring eligibility for the concessions may prove impossible when an exit of a principal occurs.
5/ Professional practices and other businesses frequently take out trauma and TPD policies for their principals and key staff. Where the purpose of the policies is not for revenue purposes, then the proceeds have the prospect of a CGT exemption. Where the nominated beneficiary is an entity such as a company or the trustee of most trusts or a business principal who is not a relative, then the TPD or trauma proceeds are subject to CGT, with the prospect of a very low cast base.
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